Keeping the rupiah stable in growth

AT its Board of Governors meeting last month, Bank Indonesia (BI) announced a combination of monetary policies aimed both at supporting economic growth and maintaining rupiah stability amid persistent global uncertainty.

Rather than adjusting its benchmark interest rate, the central bank kept the BI-Rate unchanged at 5.75%, raised the Deposit Facility (DF) rate to 5% and announced a gradual reduction in banks’ reserve requirements to provide greater flexibility for credit expansion.

At the same time, BI reinforced its foreign exchange stabilisation strategy through spot intervention, offshore non-deliverable forwards (NDFs) and domestic non-deliverable forwards (DNDFs).

While these measures serve different purposes, they reflect a broader challenge facing emerging market central banks: how to stimulate domestic economic activity without creating additional pressure on the currency.

What makes BI’s latest policy decisions particularly interesting is its apparent attempt to address these competing objectives through separate monetary instruments rather than relying solely on changes in the benchmark interest rate.

Viewed together, these measures reveal a more differentiated approach to monetary policy.

Rather than relying on a single instrument to balance growth and currency stability, BI appears to be assigning separate tools to distinct but interconnected objectives.

Lower reserve requirements create room for credit expansion, a higher DF rate supports the floor of short-term money market rates, while foreign exchange interventions seek to contain excessive rupiah volatility.

Although this combination offers greater policy flexibility, it also raises an important question: whether the effects of one instrument will undermine the objectives of another.

Start with reserve requirements, which will decline for conventional banks from 9% to 8% in November and 7% in December, freeing up part of the liquidity that banks previously had to maintain at the central bank.

That should increase balance sheet flexibility without requiring a cut in the BI-Rate.

Yet, the adjustment in macroprudential liquidity incentives means the headline reserve reduction does not represent an equivalent net liquidity gain for every institution.

Next comes the less intuitive decision to raise the DF rate while keeping the policy rate unchanged.

A higher return on overnight placements at BI can help stop an influx of liquidity from pushing overnight market rates excessively low.

This matters when investors are comparing rupiah assets with dollar alternatives.

However, the facility does not establish a binding floor under government bond yields, which depend on inflation expectations, issuance, global rates and risk premiums.

The exchange rate strategy completes the design.

Compared with selling dollars in the spot market, a DNDF transaction settles the exchange rate difference in rupiah rather than delivering the foreign currency principal.

This allows BI to provide hedging protection and reduce pressure on the spot market while preserving foreign reserves.

Research by the International Monetary Fund finds stronger evidence that the hedging tool reduces forward market liquidity pressures and exchange rate volatility, rather than permanently strengthening the rupiah.

This distinction matters because currency depreciation driven by economic fundamentals does not necessarily need to be prevented.

Instead, smoothing excessive exchange rate volatility through hedging instruments could provide BI with greater flexibility to support domestic growth without relying on higher policy rates.

Yet preserving foreign reserves does not mean that DNDF intervention is without cost.

While such intervention may be effective in addressing temporary foreign exchange market disruptions, persistent rupiah depreciation could result in repeated settlement losses when BI holds US dollar-selling DNDF positions.

Since these settlements are paid in rupiah, they can increase banking system reserves and expand the monetary base, potentially adding downward pressure on short-term money market rates. This creates another policy challenge: the additional liquidity could undermine BI’s efforts to maintain attractive returns on rupiah assets.

Against this backdrop, BI’s decision to raise the DF rate to 5% could also be interpreted as an attempt to strengthen the floor of short-term interest rates as banking liquidity expands.

The growth channel has its own weakness.

Credit expanded 13.26% year-on-year in September, yet unused loan commitments exceeded 2.5 quadrillion rupiah (US$14bil).

Additional reserves cannot compel businesses to borrow or banks to take risks. Furthermore, raising the DF return increases the attractiveness of parking funds at the central bank.

The same device supporting the short-term rate floor may therefore dilute some of the incentive to lend.

Inflation further limits the room for experimentation. September’s 3.28% annual inflation remained within the central bank’s target corridor but close to its upper boundary.

If persistent depreciation raises import costs, liquidity accommodation becomes harder to defend even when exchange rate volatility is contained.

Derivatives can smooth adjustment; they cannot repair deteriorating macroeconomic fundamentals.

Ultimately, the success of BI’s policy strategy will depend not on the number of instruments deployed but on how effectively they work together to support growth without compromising monetary stability.

Lower reserve requirements must translate into productive lending, while higher short-term interest rates should preserve the attractiveness of rupiah assets without unnecessarily increasing borrowing costs.

Meanwhile, DNDF intervention should help contain excessive exchange rate volatility without creating substantial liquidity management and sterilisation costs.

These outcomes will be particularly important, as persistent depreciation and inflationary pressures could narrow BI’s policy flexibility.

The challenge, therefore, is not simply to balance growth and currency stability but to ensure that the measures supporting one objective do not undermine the other.

If managed effectively, this approach could give BI greater room to support economic growth while maintaining investor confidence and stability in the rupiah. — The Jakarta Post/ANN